Understanding uniformity and diversity in state corporate income taxes.

By comparison, the property factor clearly exhibits at least three problems. First, the user cost of capital would arguably provide a better measure than asset values of the contribution of capital to the earning of income. Second, property is valued at original cost and is kept in the property factor until it is retired, with no adjustment for either depreciation or inflation. Finally, and more fundamentally, the property factor considers only tangible property; the intangible assets that are the "crown jewels" of the modern corporation are ignored.

It would, of course, be difficult to deal satisfactorily with these issues. The user cost of capital requires knowledge of the opportunity cost of capital, as well as the rate of economic depreciation. Adjustment for depreciation and inflation would be an unwelcome complication. It is difficult to know either the value or the location of intangible assets. These problems, especially the intractability of the third, may explain why there appears to be little interest in modifying UDITPA's definition of property, which also provides substantial interstate uniformity.

UDITPA's definition of the sales factor has been subject to considerable controversy and litigation. Most obviously, there is a gross inconsistency between attributing sales of tangible property to the state of destination and attributing other sales (i.e., of intangible products and services) to the one state where the most income producing activity occurs, as measured by the cost of performance---essentially to the (or a) state of origin. Because the UDITPA rule makes no sense, some states also attribute sales of intangible property to the state of destination and some, while following an origin-based rule, attribute sales in proportion to costs of production, instead of on an all-or-nothing basis. In short, uniformity is lacking in this area. (14)

While sales might seem to be a straightforward concept, UDITPA speaks of "gross receipts," without defining it. Some taxpayers have tried to interpret this language to include sales of financial assets, which for some corporations may exceed sales of goods and services. For the most part courts have refused to accept this interpretation.

What UDITPA Left Out

As is clear from its name, UDITPA is concerned only with the "division of income." Thus, it does not deal with three other important issues: the definition of the income to be divided, standards for jurisdiction to tax--the kinds and levels of in-state activities that would establish taxable nexus, and the delineation of the corporate group whose income would be divided, i.e., standards for requiring members of a group to file a combined report. (15) Because of convergence to conformity with the federal definition of income, the first of these gaps is not particularly problematical. By comparison, the failure to consider taxable nexus was arguably a fatal flaw, as it fueled the fears that followed the decision in Northwestern Portland Cement, to be considered next. The failure to consider combination arguably contributes to lack of uniformity in this area and may have led to controversy with our trading partners in an episode to be described below.

JURISDICTION TO TAX: NORTHWESTERN PORTLAND CEMENT AND ITS LEGACY

In 1959 the U.S. Supreme Court issued decisions in two cases involving state assertions of nexus that undercut the widely held view that a state could not impose its income tax on an out-of-state corporation engaged solely in interstate commerce. (16) By finding in favor of the state in both of these cases--and refusing to hear a case where the taxpayer's only in-state activity was solicitation of sales (International Shoe Co. v. Fontenot, 359 U.S. 984, 1959)--the Court set off a political firestorm, because of fear that there was little practical limit to state assertion of nexus. Before the year was out, the Congress had enacted P.L. 86-272, which contained a statutory restriction on state assertion of nexus and mandated a Congressional study of state taxation of interstate commerce. This four-volume study, commonly called the Willis Report, after the chairman of the House commit tee that undertook it, is perhaps the most comprehensive ever of this area.

The Willis Report included a proposal for federal legislation that would have brought substantial uniformity to state corporation income taxes, except in regards to rates, but would have involved unprecedented curtailment of state fiscal sovereignty. The states were able to fight off the proposed legislation, but, as argued below, this may have been a Pyrrhic victory.

P.L. 86-272 and the Creation of Nowhere Income

The lasting legacy of P.L. 86-272 was to prohibit state assertion of jurisdiction to impose an income tax if the potential taxpayer's only activity in the state is solicitation for sales of tangible property delivered from outside the state. Although this provision was enacted as a stopgap measure, it is still on the books.

It was apparently expected that this limitation would merely codify current practice and would primarily benefit small- to middle-sized businesses (see U.S. House of Representatives, 1964, pp. 422, 438). But this bright-line test of nexus provides a roadmap for the creation of "nowhere income," income that no state subjects to tax: avoid making sales where you have nexus and avoid nexus where you make significant amounts of sales. This might sound like a Procrustean bed for some corporations, who might not be able to conduct business effectively without having in-state activities that exceed those protected by P.L. 86-272. But the fact that many states base corporate tax liability on separate corporate reporting for affiliated entities spares many corporations the need to lie in that bed. One member of a corporate group may make substantial amounts of sales into a state where it lacks nexus and, thus, pay no tax, even though its affiliates do have nexus in the state (but may not have significant amounts of sales there). It appears that the Willis Committee did not pay enough attention to this possibility. When sales-only apportionment is thrown into the mix, there may be significant amounts of nowhere income. (17)

Was Ignoring Nexus UDITPA's Fatal Flaw?

One wonders how different history might have been if UDITPA had dealt with nexus, particularly if it had done so in a responsible manner. Writing five years after the decision in Northwestern Portland Cement, the authors of the Willis Report noted, "In most States the statutory language is broad and indefinite." They concluded, "The great majority of States simply impose taxes on corporations 'deriving income from sources within the State,' 'doing business within the State, 'engaged in' or 'carrying on' business within the taxing State." They continued, "The breadth of the language in the Northwestern decision, when combined with the refusal to review the two Louisiana cases, suggested to many observers that very marginal activities might be held to create taxable relationships. It was concern with this possibility that provided the primary impetus for the enactment of public Law 86-272. Nevertheless, it is generally assumed that a State does not have the power to impose an income tax in every case in which a permissible apportionment formula would attribute some income to the State...." (U.S. House of Representatives, 1964, pp. 141, 142. Italics added.)

But what if states had voluntarily asserted nexus only when the in-state presence of one or more of the apportionment factors, including sales, exceeded a de minimis level? (18) What if UDITPA had contained such a rule and state adoption of that rule had been widespread, if not universal? If Minnesota had adopted such a rule, Northwestern Portland Cement might never have gone to trial, because the taxpayer's sales in Minnesota far exceeded a de minimis amount. Given that fact pattern, if the case had been brought and had reached the U.S. Supreme Court, the Court presumably would have found for the state. But its opinion might not have been interpreted as giving the states carte blanche, as its actual decision was. (19) The political firestorm might not have occurred, especially if the expanded UDITPA had been on the books and most states had adopted the hypothetical nexus standard, and P.L. 86-272 might never have been enacted. But, as they say, this is "crying over spilt milk" (see McLure, 2005, for more on crying over spilt milk).

The Multistate Tax Compact and Creation of the Multistate Tax Commission